ECB hike opens door to bond volatility

If there’s one lesson from the European Central Bank’s latest monetary policy meeting, it’s that bond market volatility is here to stay.

By making it clear that stress points in the banking industry — as well as economic data — will guide future rate decisions, ECB Chief Christine Lagarde paved the way for bond-market gyrations to remain elevated for the remainder of the year as traders try to figure out when the ECB’s hiking cycle is due to end.

While policymakers stuck with their earlier guidance and delivered a hefty 50-basis point hike on Thursday, they declined to give any steer on the future trajectory of interest rates as concerns over the banking sector simmer both in Europe and the US.

“Today, forward guidance ended for good,” said Frederik Ducrozet, head of macroeconomic research at Banque Pictet & Cie SA. “Developments in the banking sector are likely to be more important drivers for the bond market than central banks or macro data.”

After a week of wild market moves — as investors honed in on embattled Credit Suisse Group AG following a trio of bank collapses in the US — Thursday’s trading underscored the continued uncertainty.

German two-year bonds — among the most sensitive to policy changes — swung between gains and losses before trading little changed after the meeting. The euro erased an advance against the dollar before veering back into the green, then gradually pared the move once again. A gauge of interest-rate volatility, meanwhile, is close to its highest since September.

“We expect market pricing of the ECB’s next steps to remain highly conservative moving forward,” said Simon Harvey, head of FX analysis at Monex. “This will naturally keep volatility high in both currency and bond markets as monetary policy is now no longer on auto-pilot to bring down inflation.”

Markets had been on a knife-edge over whether the ECB would opt for a quarter- or a half-point hike. The latter was seen as almost certain a week ago, yet concerns over the potential for financial stress have changed the outlook. Some analysts had even suggested policymakers could pause the hiking cycle to allow markets to settle after the collapse of the US banks, which fuelled jitters over systemic stress and upended the outlook for borrowing costs.

After Thursday’s decision, fund managers were left to plot a path through the turbulence.

David Zahn, head of European fixed income at Franklin Templeton, is looking to move back to a neutral position in interest-rate risk in Europe, from underweight. “We believe the ECB will overtighten interest rates given the inflation target as the current volatility hits the European economy,” he said.

But conviction in just when to increase exposure to duration is a question that’s likely to keep plaguing investors.

Just days ago, traders had been betting the ECB would raise rates to a record 4.2% by October, before paring those wagers back to around 3.3% by July now. Euro-area bond yields shot higher once again late Thursday afternoon, matching a selloff in Treasuries after reports that major lenders were in talks to shore up another embattled US regional bank.

Despite the potential for banking turmoil to continue, “taking on duration risk amidst all the volatility would need to be based on a conviction that banking woes will lead to recession,” said Marc Ostwald, chief economist and global strategist at ADM Investor Services. “It may be premature to make that judgment.”